Dynamic Taxation, Private Information and Money

The objective of this paper is to study optimal fiscal and monetary policy in a dynamic Mirrlees model where the frictions giving rise to money as a medium of exchange are explicitly modeled. The framework is a three period OLG model where agents are born every other period. The young and old trade in perfectly competitive centralized markets. In `middle age', agents receive preference shocks and trade amongst themselves in an anonymous search market. Money is essential in this market. Since preference shocks are private information, in a record-keeping economy without money, the planner's allocation trades off efficient risk sharing against production efficiency in the search market and average consumption when old. For a government to replicate this outcome in a monetary economy without record-keeping, distortionary taxation of money balances is needed if other taxes are constrained to be lump-sum and/or linear.